Three reasons Baby Bunting in booming

Three reasons Baby Bunting in booming

Eleanor Swanson, Analyst

Baby Bunting is a baby specialty goods retailer with a network of 50 stores across Australia. The company has 12% share of the $2.4 billion of the domestic baby goods market, generating $300 million of sales last financial year. In this article, we highlight three reasons why Baby Bunting is booming, and why it is one of our top picks in the Australian small cap retail sector.

1. Market Consolidation: Bye-bye baby retailers 

During FY18 there was an unprecedented level of store closures in Australia’s baby retail sector. Four of Baby Bunting’s major competitors went into administration including Babies “R” Us and Baby Bounce. The collapse of these speciality retailers has left $138 million or almost half of Baby Bunting’s annual turnover up for grabs. Given that its nearest competitor now has just three stores, Baby Bunting is in a unique position to benefit from the significant consolidation within its sector. We expect the company to capture approximately 30% of the sales from these defunct retailers where store catchments overlap.

2. Store roll-out: Baby Bunting is growing up 

Baby Bunting intends to increase its store count from 50 to 80, with six new stores opening FY19. In December 2018, the company opened its first mall location at Chadstone, the biggest shopping centre in the Southern Hemisphere. Not only will Chadstone be a top performing store, it represents a new opportunity for Baby Bunting to branch out from its big-box, home-centre roots, to a premium retail offering in malls. The mall opportunity is not factored into its current store-roll out plan.  Baby Bunting is one of the few retailers on the ASX with both a store roll-out story and a significant market share opportunity. We expect Baby Bunting to deliver up to 15% revenue CAGR over the next three years.

3. Scale benefits: The big kid on the block 

The size and scale of Baby Buntings’ store network and operations creates a formidable barrier to entry. First time parents wish to see, touch and receive advice on big ticket items such as car seats and prams due to the emotional nature of the purchase. Suppliers are conscious that they need an in-store presence. Given Baby Bunting is the sole baby retailer with a footprint in 5 out of 6 states, it is crucial that a strong relationship with the retailer is nurtured by suppliers. Baby Bunting is therefore in the driver’s seat when negotiating buying terms and product exclusivity deals. Its sheer size means it is also eligible for large volume discounts, which competitors with three or less stores cannot attain. As a result of its market dominance, Baby Bunting can offer competitive pricing and product differentiation, driving in-store traffic whilst expanding gross margins.

Conclusion: The Baby Bunting boom continues  

Baby Bunting presents a rare opportunity to own a retailer that is growing sales and expanding margins.  An unprecedented level of market consolidation in the Australian baby retail sector is allowing Baby Bunting to grow sales and profitability materially in a short space of time. Over the next few years, we expect Baby Bunting’s earnings to double as it continues to benefit from market consolidation, revenue growth and improving scale benefits.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrail.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Hey Earnings, where’s my Cash?

Hey Earnings, where’s my Cash?

James Miller, Portfolio Manager

How can Treasury Wine Estates report cashflow of $27m and profit of $219m? Should we be concerned?

One of the joys of analysing investment opportunities is that every opportunity is unique. In making investment decisions, we look at each company through a slightly different lens. During the February reporting season one of the key issues that arose was the mismatch between cashflow and earnings for many companies.  In the article below we explore why this happens, and how it affects our decision making.

There are three key areas to focus on:

  1. What drives the difference between cashflow and earnings?
  2. When should you be concerned?
  3. How does it affect our decision making?

We conclude that recurring or deteriorating cashflow issues may be symptomatic of a broader issue in the business. In our Absolute Return Strategy, poor cashflow can be a red flag for further research of potential short opportunities.

1. What drives the differences between cashflow and earnings? 

Changes in working capital can often explain the key differences between operating cashflow and earnings. Key drags on cashflow for a company can be:

  • Increasing receivables – a company is yet to be paid from customers
  • Reducing payables – suppliers being paid quicker by the company
  • Increasing inventory – a company is yet to sell goods they have produced

Ideally you have high payables, low inventory and low receivables. The combination means a company is getting paid quickly, for goods you recently produced, and not having to pay your suppliers quickly.

2. When should you be concerned? 

Cashflow is a concern if you believe that the company isn’t going to receive that cash at some point in the future. Two companies that had poor cashflow conversion in the Dec 18 half were engineering firm Worley Parsons and wine exporter, Treasury Wine Estates. Cash conversion is a ratio of operating cashflow to accounting earnings – the higher the better.

We weren’t concerned in February 19 when Worley Parsons announced operating cashflow of $21m versus profit of $98m. For companies with skinny margins and large revenues, such as Worley Parsons, a small move in timing of receivables or payables can have large effects on cashflow. To put it in context, in that 6-month period Worley had ~$2.6b of cash receipts from customers and paid nearly $2.6b in payments to suppliers. Put simply, the scale of the cashflows in and out of the company during the period were large compared to the profit, so a couple of days change in payment timing can make all the difference.

One result that warrants more research was Treasury Wine Estates (TWE). Management went to the effort of explaining that, whilst their 31 December 2018 cash conversion was just 54%, at the end of January this had stepped up to 85%. A possible explanation of changes in cash conversion is the timing of sales. One key question that springs to mind is whether Treasury’s customers have been receiving better payment terms to get sales completed in the half year?

For the contracting sector (think companies like Cimic, Monadelphous and Lend Lease) poor cashflow always requires investigation.  The first sign of a large construction contract encountering problems is often the customer stopping or slowing payments to the contractor until the problem is rectified.  Given that the profit on construction contracts is recognised by a management assessment of completion progress, the profit can be more subjective than the cashflow.

3. How does it affect our decision making? 

Earnings are the key metric we use to assess most companies.  Earnings are far less volatile than cashflow and enable the best comparison for valuation between companies on a timely basis. For example, doing cross-industry comparison, we can compare banks (with very messy cashflows) to resource companies effectively using earnings as the primary metric.

However, understanding a business’s cashflow is also critically important. Typically, a short-term hiccup in cashflow, that is well explained by management, is not a concern.  But recurring poor cashflow, or deteriorating cashflows in certain industries, can be a warning sign.

Summary 

Making investment decisions involves looking at many aspects of a company’s financial position. One critical component is understanding a company’s cashflow. Recurring or deteriorating cashflow issues may be symptomatic of a broader issue in the business. In our Absolute Return Strategy, poor cashflow can be a red flag for further research of potential short opportunities.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrail.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Why WorleyParsons is set to benefit from the oil and gas cycle

Why WorleyParsons is set to benefit from the oil and gas cycle

Blake Henricks, Deputy Managing Director & Portfolio Manager

Worley Parsons is an Australian engineering company that specialises in global oil and gas projects. In this article, I explain why Worley Parsons is set to benefit as the oil and gas investment cycle turns positive. I’ll outline our investment thesis in Worley Parsons, focusing on three key areas.

  1. The oil and gas investment cycle
  2. Cost-out initiatives
  3. Worley Parsons valuation

The article will provide you with a deeper understanding of ‘What Matters’ for Worley Parsons and why I believe it is a material opportunity for our investors.

1. The oil and gas investment cycle 

At the peak of the oil and gas cycle in 2014, oil soared to US$115 per barrel. The subsequent collapse in the oil price to below US$30 per barrel in 2016, resulted in significantly reduced capital expenditure (capex) in oil and gas projects globally, as major energy producers focused on protecting balance sheets.

As shown below, the reduction in oil and gas expenditure significantly impacted Worley Parsons’ revenue, which fell 50% from their peak in 2014.

Worley Parsons Revenue ($AUDm)

Source: WorleyParsons Financial Data

After four years of underinvestment, we believe we are at the bottom of the oil and gas investment cycle. Our research indicates that investment in oil and gas projects needs to return to meet global energy demand. Worley Parsons is set to benefit from the return of the oil and gas cycle. Pleasingly, early indicators are looking strong. Over the past 6 months, Worley Parsons has won many contracts giving us confidence that the worst is behind us.

2. Cost-out initiatives 

Worley Parsons has embarked on significant self-help initiatives over the past few years. A disciplined focus from management has led to a reduction in costs of around $500m since 2016. For a business that made $299m of EBIT on FY18, the cost-out has been material.

In addition, Worley Parsons announced a transformational acquisition of US based Jacobs’ Energy, Chemicals and Resource business in 2018. Jacobs is also a global engineering firm, with less oil and gas exposure. The acquisition provides attractive synergies and strong EPS accretion for shareholders. Importantly, the purchase was conservatively funded and positions Worley Parsons as a market leader in its key categories. Once the acquisition settles, expected early to mid-2019, the purchase provides shareholders with a more diversified, stable earnings profile and gives Worley Parsons the scale and capabilities to bid on some of the largest energy projects around the world.

3. Worley Parsons valuation

Worley Parsons is incredibly undervalued. Today, it is trading close to a market multiple on FY20 earnings, when factoring in synergies from the recent Jacobs acquisition.

The recent 30% fall in oil price in late 2018 and the near doubling of shares on issue has caused the Worley Parsons’ share price to underperform in the short-term. In our view, the market has incorrectly assumed that lower oil prices will cause a sustained lower level of investment in oil and gas projects. Whilst lower oil prices may cause a pause in 2019 capex, investment in global oil and gas projects needs to return over the medium term for global oil supply to keep up with demand. At this point in the capex cycle, Worley Parsons is incredibly undervalued.

Conclusion 

After four years of underinvestment, the oil and gas cycle is turning positive. Worley Parsons is well positioned to benefit as the market leader in oil and gas engineering. In our view, Worley Parsons is significantly undervalued at this point in the cycle. With significant earnings leverage and a compelling valuation, Worley Parsons will be a material opportunity for patient investors.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrail.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Weathering the storm: An opportunity in Australian Insurance

Weathering the storm: An opportunity in Australian Insurance

Scott Olsson, Analyst

The hail storm that hit Sydney late last year made a lot of headlines, but has not changed our fundamental view that insurance is an attractive sector in the current environment. Losses from weather events are part and parcel of running an insurance business. While they introduce profit volatility and can have some flow-on impacts, we believe the major insurers are in a strong position to mitigate and offset these factors.

Sydney hail storm one of the biggest events of the past 30 years

The Insurance Council of Australia’s latest estimate is that this event will cost the insurance industry $673m. Our analysis suggests the cost could eventually reach $1.5-2.0bn once all claims are reported and paid, which would make it one of the top five most expensive weather events of the past 30 years and possibly the most damaging hail storm since the Sydney hail storm in 1999.

Source: Insurance Council of Australia, Firetrail Investments. Notes (1) Red bar indicates Firetrail estimate of ultimate losses from Dec-18 Sydney hail storm. Most recent estimate from Insurance Council of Australia is $673m.

Direct impacts are quantifiable and contained 

With 60-70% combined share of the NSW Motor and Home markets, at face value such an event could be disastrous for IAG’s and Suncorp’s FY19 profits. Both however, have very strong levels of protection which restrict losses and pass the excess on to reinsurers. The net costs of this event are capped at $169m for IAG and $250m for Suncorp, despite the gross cost likely being multiples of this amount.

Both insurers also have allowances in their guidance for a “normal” level of total weather losses in any given year. While the Sydney event does increase the chance that IAG and Suncorp exceed these allowances in FY19, both also have covers in place that provide protection if claims from multiple weather events over a 12-month period begin to add up.

The combination of various reinsurance protections mitigates a substantial proportion of the direct costs of the hail storm. We believe indirect impacts are more relevant for ongoing profitability.

Price lever can be pulled to offset indirect impacts

Apart from the actual claims from large weather events, there are two main flow-on impacts that need to be considered:

Increases in reinsurance costs

The price IAG and Suncorp pay for reinsurance would normally be expected to rise following large claim events, but over the years both have shown a strong ability to negotiate reasonably attractive terms. Most recently, IAG renewed its reinsurance program for 2019 at “relatively flat” rates, despite incurring losses on its 2018 program.

The ability of IAG and Suncorp to obtain favourable terms can be attributed to the significant surplus capacity that exists in global reinsurance markets, IAG’s and Suncorp’s position as two of the largest reinsurance purchasers in the world, and the attractiveness of Australia as a source of diversification for global reinsurers.

Supply chain pressures

The high number of repairs needed in a short space of time after a weather event can place insurer supply chains under strain. Following a hail storm, motor repairer capacity typically becomes stretched and costs are pushed higher. While any claims blow-outs from the hail storm should be covered by reinsurers, it is inflation in the day-to-day claims over the following six months that can put pressure on IAG and Suncorp.

Industry-wide impacts lead to re-pricing 

The indirect impacts from higher reinsurance costs and supply chain inflation tend to affect all insurers, which typically drives a pricing response across the industry (albeit sometimes with a lag). Following a run of large weather events in 2010/11, Home & Contents pricing increased by 10%+ pa for 3-4 years. Given reasonably rational Motor and Home markets currently, we believe there is a case for recent price increases to continue or perhaps accelerate.

Source: Insurance Council of Australia

Shelter from housing and consumer weakness

Stepping back from the noise of weather claims, one storm that insurers are well positioned to navigate is the current weakness in the housing market and Aussie consumer. While affordability pressures can have some impact, demand tends to be reasonably resilient given the nature of insurance products as mitigants of cash flow and asset risk.

Insurers have typically outperformed relative to the ASX200 during more bearish periods for markets and/or the economy. The chart below highlights how IAG and the ASX200 performed through the GFC. While the GFC is an extreme example, it illustrates the value the market places on the defensiveness of insurance in tougher times. We believe this is an attractive feature against the current consumer backdrop.

Source: FactSet, Firetrail Investments

Summary

The risk insurers face from large weather events will always be a key talking point for investors, but IAG and Suncorp have shown an ability to successfully mitigate a large portion of the P&L and capital volatility through reinsurance and re-pricing. With defensive characteristics in an increasingly difficult economic environment, we believe domestic insurance represents an attractive sector to be exposed to.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Our #1 stock pick for 2019

Our #1 stock pick for 2019

Blake Henricks, Deputy Managing Director & Portfolio Manager

Nufarm is an Australian company that specialises in chemical crop protection globally. It produces products to help farmers protect their crops against damage caused by weeds, pests and disease.

There are two key reasons we believe Nufarm is one of the most compelling opportunities in the Australian equity market today:

  1. Industry consolidation
  2. Omega 3 opportunity

This article explains why Nufarm is undervalued today and why we believe it will be a future winner for our investors over the medium term.

Why Nufarm is undervalued

If you invested in Nufarm at the start of the year it has been a tough investment. The share price has fallen almost 30% and Nufarm is trading at a substantial discount to its global peers.

The underperformance has been driven by two key issues:

  1. Australian drought – The Australian drought in 2018 significantly impacted Nufarm’s Australian earnings (~15% of total company earnings). The drought was a one in fifty year event. But investors need to remind themselves that droughts are cyclical in nature. They are not structural issues and whilst we do not know when it will rain, we like to take the contrarian approach of buying in drought and selling in rain.
  1. Glyphosate concerns – Glyphosate is the world’s most commonly used herbicide. It has come under controversy this year following a US law suit against Monsanto, which ruled that ‘RoundUp’ (which contains glyphosate) caused a former school gardener’s cancer. Glyphosate products currently account for almost 20% of Nufarm’s earnings so this is an issue we are monitoring closely. To date there are no glyphosate cases against Nufarm.

Whilst controversial, we don’t believe there is any reasonable scenario where chemical crop protection is banned globally. Doing so could reduce global crop yields by 40% which would result in a global food shortage. The issue is multi-faceted, but we believe Nufarm is well-placed in any reasonable outcome from the controversy.

The Australian drought and glyphosate concerns have created a buying opportunity for medium to long term investors. Below we explain why we believe Nufarm will be a future winner for our investors.

Industry consolidation

The Global crop protection market is a US$50bn industry. The industry has traditionally been dominated by six large players including multinational brands such as Bayer, Syngenta, Monsanto and BASF. However, the crop protection industry has been going through a major period of consolidation over the past two years. Since 2016, the six largest players have consolidated to four.

Nufarm is a big beneficiary from industry consolidation. Less competition means a better pricing environment across the market. In addition, the frenzy of mergers and acquisitions across the industry has resulted in forced asset sales, giving Nufarm a once in a lifetime opportunity to buy high quality assets directly from competitors at great prices. With competitors distracted and internally focused, we believe Nufarm has an opportunity to gain market share as a focused, independent alternative supplier of crop protection to its customers.

Omega-3 opportunity

Fish oil is a rich source of Omega-3 fatty acids. It is derived from sustainably caught unpalatable fish such as anchovies and other fish by-products and used predominantly as aquaculture feed in fish farms. Omega-3 is required to meet the world’s growing appetite for fish. However, as Chart 1 highlights, the world is short natural sources of Omega-3.

Source: Firetrail

Nufarm has developed the World’s first plant-based source of Omega-3 in partnership with the CSIRO.  Whilst there are competitive technologies being developed, Nufarm will be first to market, with patents beyond 2030 and regulatory approval for commercialisation expected in 2019.

In our view, the Omega-3 opportunity represents 40% additional upside to the current share price despite earning nothing today.

Conclusion

Nufarm has fallen over 30% this year and is currently undervalued versus its global peers. Whilst there are issues regarding the Australian drought and glyphosate concerns, we believe there is material upside to today’s share price. In our view, industry consolidation and the Omega-3 opportunity will provide significant earnings growth for the company. We believe Nufarm is one of the most compelling investment opportunities in the share market today.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Raw material inflation: Picking the winners and losers

Raw material inflation: Picking the winners and losers

Patrick Hodgens, Managing Director & Portfolio Manager

Costs are rising. Raw material inflation is coming through the supply-chain across industrial stocks. As a result, earnings pressures are emerging in many companies with exposure to raw materials. We have seen this in companies with exposure to oil (such as transportation, rubber or plastics) and pulp (i.e. Paper and building materials). Share prices have fallen as a result of downgraded earnings.

This article takes a closer look at some of the companies impacted by rising raw material costs, as well as where we are seeing the risks and opportunities. We conclude that now may be the time to invest in companies that have been oversold due to cost inflation concerns, particularly those that are able to pass rising costs through to their customers.

The losers

The Australian equity market has seen a number of companies downgrade FY19 earnings due to rising raw material costs. In October, James Hardie downgraded earnings after reporting 2Q19 results. FY19 profit guidance was reduced by approximately 6% citing increases in key input costs such as pulp, freight and cement. The share price subsequently declined 15%.

In our view, the James Hardie share price decline is an opportunity to buy a high-quality business, with solid growth, at a compelling valuation. Over the medium-term, we expect input costs to revert, while James Hardie should be able to deliver strong earnings growth underpinned by high single digit revenue growth through a combination of market and share growth in the US housing market.

Ansell is another company negatively impacted by rising raw material costs. Ansell manufactures and sells gloves and other protective rubber and latex products in the healthcare and industrial sectors. The key raw material inputs for Ansell are highlighted in Chart 1.

Rising raw material costs are a major headwind for Ansell’s earnings. Key raw material inputs including Fibres and Yarns (for example, Cotton) and Nitrile Latex have seen significant price rises over the year, up 13% and 27% respectively. In August, the company’s management downgraded FY19 earnings guidance by approximately 7%, resulting in a 9% fall in the share price. The Ansell downgrade highlights the impact higher raw material prices can have on profit margins, particularly for companies unable to increase prices and pass these costs onto their customers.

Chart 1 – Ansell Raw Material Input Costs (% FY18)

Source: Company data

What happens next? Picking the future winners

Some companies are better placed than others. There are companies in favourable industry structures that are able to pass rising costs onto their customers. Below we highlight two companies that we believe meet the above criteria.

Qantas Airways

Since July 2018, Qantas has fallen by approximately 11% on the back of rising cost concerns, in particular higher oil prices. There is no doubt that higher oil prices impact Qantas’ earnings. However, what makes Qantas unique is its ability to pass these higher costs through to customers. Over the past year, we estimate Qantas has increased its domestic airfares by 7%. At the same time management are continuing to deliver cost out initiatives to offset the impact of higher fuel costs.

As the domestic market leader in a rational duopoly we believe Qantas is well placed to raise ticket prices to offset the impact of higher future oil prices. At current valuations, trading on a price to earnings multiple of 9.4x vs global peers at 12x – in a more favourable industry structure – Qantas continues to represent a compelling high conviction investment in portfolios for our clients.

Amcor Ltd

Amcor is the global leader in flexible consumer packaging. One of the key raw material inputs into Amcor’s flexible packaging business is resin (plastic), which reached new highs in April 2018. However, Amcor has contractual raw material inflation pass through to its underlying customers. Over the short term, there is a lag of approximately 3-months to recover raw material cost increases. However, over the medium-term, Amcor is well placed to pass almost 100% of raw material cost inflation through to its underlying customers.

In August, Amcor announced the acquisition its largest competitor Bemis for US$6bn. Bemis enhances Amcor’s position by giving it a strong position in North America in addition to Amcor’s existing European and emerging market positions. The acquisition truly establishes Amcor as the global leader in packaging, able to offer global solutions. With a solid track record of generating value from acquisitions, good organic growth and a compelling valuation, Amcor is a high conviction position in the Firetrail portfolios that is well placed to navigate the current market environment.

Conclusion

Companies with exposure to raw material inflation will continue to see earnings pressure into FY19. As stock pickers, the key question we are asking ourselves is who are the winners and losers impacted by rising raw material costs?

In our view, investors should be wary of companies in highly competitive markets with a non-differentiated product, which may not be able to pass rising raw material costs on. Companies in market leading positions such as Qantas and Amcor who are able to pass higher costs onto their underlying customers will fare better in this environment. Businesses with strong earnings growth such as James Hardie, which has been sold-off heavily also represents a compelling long-term opportunity for our investors.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.